Who pays for sustainability? An analysis of sustainability-linked bonds
This paper analyses sustainability-linked bonds (SLBs), which tie bond coupons to sustainability performance targets. They find issuing an SLB yields an average premium of -9 basis points on the yield at issue compared to a conventional bond, and the savings for an issuer exceed the maximum penalty for failure to meet the target.
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OVERVIEW
Sustainability-linked bonds (SLBs) are essentially corporate bonds that tie the coupon rate to the issuer’s sustainability performance objectives. This paper analyses the pricing of SLBs compared to conventional bonds and investigates the drivers behind the sustainability premium.
Main Findings
The paper finds that issuing an SLB yields an average premium of -9 basis points on the yield at issue compared to a conventional bond. However, this premium decreased over time. On average, the savings from this reduction in the cost of debt exceed the maximum potential penalty that issuers need to pay in case of failure of the sustainability performance target. This suggests that SLB issuers can benefit from a ‘free lunch’, i.e. a financial benefit despite not reaching the target.
Drivers of the sustainability premium
The paper shows no clear relationship in empirical data between the yield at issue and the coupon step-up agreement of SLBs. Instead, an issuer’s first SLB seems to command a significantly larger premium, suggesting that investors recognize the first SLB as a credible signal of a company’s commitment to sustainability.
Relevance to ESG investing
As companies worldwide pledge to achieve net-zero emissions and other sustainability targets, understanding who pays for this shift to sustainability is critical. SLBs create a financial incentive for issuers to achieve specified sustainability targets. By issuing an SLB, issuers can signal to ESG investors that they are committed to reaching a specific sustainability target. ESG investors, in turn, may prefer the securities of companies willing to demonstrate such a commitment.
Recommendations
The findings of this paper support the case for issuers to consider sustainability-linked bonds as an alternative source of financing. Issuers can benefit from a reduced cost of debt, despite the risk of not meeting the sustainability performance target. On the other hand, investors looking to gain exposure to companies with an ESG commitment may consider investing in SLBs.
